Let the Banks Fail: Why a Few of the Financial Giants Should Crash
So far, much of Washington’s ad hoc, ham-fisted response to the economic crisis has been based on the dictum that the financial institutions must be prevented from taking their losses.
That should come as no surprise. Big finance’s lobbyists have been all over the "bailout" (it should be bailouts, plural) from the very start, Wall Street pumped piles of cash into the elections — AIG, recipient of tens of billions in taxpayer largesse, ponied up $750,000 for both the Democratic and Republican conventions — and the whole thing’s been designed by "free-market" ideologues who came to Washington directly from Wall Street.
But the hard reality is that the institutions that created this mess have to take their losses — no doubt huge losses in many cases — if we're to have any chance of avoiding a deep recession that drags on for years.
Some will be wiped out in the process, but propping up firms that have massive -- and not entirely known -- quantities of so-called toxic securities on their books only delays the inevitable day of reckoning.
The rot has spread far beyond real estate, but that offers a nice concrete example of the danger of keeping Big Finance from taking its lumps. So far, their lobbyists have fought off attempts to force them to renegotiate mortgages, especially plans that call for writing down the value of the loans to reflect the post-bubble market. This is understandable. But the reality is that there are a lot of homes "under water" — that is, worth less than the value of their mortgages — and a lot of mortgages with "teaser rates" are about to adjust upward. Foreclosures only drive down the value of the whole market further -- who wants to pay today's fair value when two other houses on the same street are headed toward foreclosure and might be had for a song in a few months?
The justification for creating the big bailout honeypot for Wall Street was that banks are hoarding money, causing a "credit crunch" that's killing the whole economy. But that’s only true to a point; while financial institutions are holding cash, including, reportedly, those billions they gouged from the taxpayers, they appear to be doing so to protect their balance sheets, and in some cases, to fund mergers. The bigger problem -- one the bailout is hardly touching -- is that trillions in home equity and retirement accounts have vanished, and there aren’t a lot of people — or firms — looking to borrow money to buy stuff or expand right now.
Economist Dean Baker explains the dominance of the "credit crunch" narrative like this:
The media "largely ignored the growth of an $8 trillion housing bubble, by far the most important economic phenomenon of the decade. Now that it has burst and sent consumption plummeting, they are blaming the economic collapse on a 'credit crunch' instead of the more obvious problem that consumers just lost $6 trillion of housing wealth and another $8 trillion of stock wealth."
We hear a lot about banks not lending to one another these days -- another reason we have to buy up shares of their tanking stocks and guarantee their funky securities. But consider that as I write, a benchmark "interbank" lending rate (the LIBOR, if you care) is at its lowest point in history, meaning that banks aren’t, in fact, charging each other an arm and a leg for cash.
But, at the same time, William Prophet, an analyst at UBS, Switzerland’s biggest bank, told Bloomberg News that "the volume of loans apparently is still close to zero, and that hasn’t changed."
People are just maxed out, and they're not borrowing or buying.
Are the Titans of Finance Too Big to Fail?
Letting the banks -- the ones that went out furthest on the ledge of those newfangled debt-backed securities and indulged in the worst lending practices -- take a beating does represent a conundrum. On the one hand, there’s an almost visceral satisfaction to the idea of letting high-flying financiers get their comeuppance. It was the titans of Wall Street, after all, who turned a housing bubble into a shaky house of cards worth tens of trillions of dollars based on little more than "irrational exuberance" and a wave of deregulation.
But, at the same time, the financial services sector -- banking and insurance -- employs over 6 million people. Last month, CitiGroup announced that it would layoff 53,000 employees, the second-largest workforce cut by a single company in American history. That will bring the total number of people out of a finance job to 180,000 this year, and those people will spend less, pay fewer taxes, and many will have trouble paying their mortgages and staying in their homes. The sector’s unemployment rate rose from 3.9 percent to 4.6 percent in just four months, between August and November.
The assertion that we should do what's necessary to avoid adding to our unemployment and other woes just at the moment would be more persuasive if not for one crucial point: our financial sector has become bloated, swimming in capacity the larger economy doesn’t need. That house of cards it built is simply too big to prop up, and spending billions to do so is only throwing good money after bad -- saving an industry that has grown out of proportion to the purpose it serves.
Here’s a fun fact about the finance industry. Historically, it’s grown and contracted along with the business cycle. When the economy was going gang-busters and businesses were expanding, it was there to provide capital and insurance and connect investors with entrepreneurs and innovators. Then, when the business cycle took its inevitable turn and the economy slowed down, it would contract. But a funny thing happened on the way to the financial meltdown; as the Associated Press noted, "when the Internet bubble burst in 2000, the sector never stopped growing. Instead, it ballooned over the past eight years to around 10 percent of the U.S. economy, puzzling economists."
It’s not such a puzzle. In large part, the continued growth of the sector was based on the explosion in derivatives -- high-value vapor -- rather than anything connected to real growth in the "nuts and bolts" economy. (As I explained in more detail here, a derivative is a piece of paper that can be bought and sold for real money but isn't attached to a concrete asset. Its value is simply derived from something tangible -- hence the name. It is, in essence, the equivalent of investors making a bet that a company, industry or just about anything else with a tangible value will move up or down.)
The recession of 2001 officially started in March, when the financial services sector employed 5.7 million people. At the time, the total value of derivatives held by U.S. commercial banks was estimated to be around $42 trillion. By the third quarter of 2007 -- before the crash -- the financial sector was employing almost 6.2 million people, and the value of derivatives held by American banks had skyrocketed to almost $170 trillion -- almost three times the value of the entire world’s economy.
During the intervening period, the "real" American economy was in doldrums: between 2000-2007, median household income dropped; the number of families living in poverty grew by almost 11 percent and the economy added jobs at the lowest rate in the post-World War II era. (I should add that those employment numbers look a lot worse when you take out the job growth in government and our uniquely inefficient health sector -- between 2001 and 2006, health care added 1.7 million (net) new jobs while the rest of the economy added zero.)
As Bloomberg reported, "The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century."
So much of the economic output of recent years has been ephemeral, fueled by the ever-growing financial industry and enabled by the deregulation for which it lobbied hard for years. When this "speculation economy" -- or at least the big chunk of it built on consumer debt and home mortgages (which I discussed in greater detail here) -- began to crash, it drove much of the real economy into the ground with it, and that’s where we stand today.
But the importance of this analysis goes beyond assigning blame. Today, we have a finance sector that is straining under the weight of a ton of fishy paper -- those much-discussed toxic securities -- and nobody knows exactly who’s holding what. What we do know is that since 2001, $27 trillion worth of bundled, debt-backed securities were issued, and a significant, if equally unknown, portion of those are nearly worthless.
This was always the fundamental flaw with the original "Paulson plan" -- buying a couple hundred billion worth of crappy paper when there’s trillions worth of the stuff on American banks’ book is tantamount to trying to bail out the Titanic with a thimble.
But more important is what these numbers suggest moving ahead. The hard reality is that these financial institutions must take huge losses on that paper or else this recession will likely deepen and drag out for years. Basic economic theory says that when a business is not sustainable and goes belly-up -- or a sector has unnecessary capacity and shrinks -- its capital, physical plant and other assets, expertise and employees will become integrated into firms that are productive.
When the Financial Tail Wags the Corporate Dog
The financial sector’s size isn’t the only thing to consider as we watch our government take a page from Venezuela's President Hugo Chavez and blow wads of state money purchasing bank stocks and those "troubled assets." The influence of the financial sector on the behavior of the rest of the corporate economy is something that we take for granted -- it’s business as usual in America -- but in a time of crisis, a rethink of the entire financial order is imperative.
The modern system of finance developed during the progressive era -- from the late 1890s through the 1920s -- and its creation was heavily influenced by the prevailing anger at the power of the huge trusts. Dispersed ownership and new forms of finance -- through stocks, corporate bonds and other securities -- were seen as an antidote to the influence of the robber barons, that handful of dynastic families who controlled key sectors of the American economy.
Since then, the original function of the financial markets -- to link investors’ capital with innovative firms -- has been turned on its head. Today, corporate behavior is very much dictated by the markets -- quarterly earnings, stock prices and the like -- and not the other way around. That’s not a good thing.
Lawrence Mitchell, a professor of business law at George Washington University, notes in his book, The Speculation Economy, that a recent survey of CEOs running major American corporations revealed that almost 80 percent would have "at least moderately mutilated their businesses in order to meet [financial] analysts’ quarterly profit estimates."
Cutting the budgets for research and development, advertising and maintenance and delaying hiring and new projects are some of the long-term harms they would readily inflict on their corporations. Why? Because in modern American corporate capitalism, the failure to meet quarterly numbers almost always guarantees a punishing hit to the corporation’s stock price.
And corporate managers’ own fortunes are tied to their companies’ share prices through bonuses, stock options and other incentives. The desire to make the financial sector happy often dwarves other imperatives; Mitchell calls it "short-termism" and suggests that making a company’s balance sheet look good quarter to quarter drives CEOs to sacrifice values like worker safety, environmental protection and other social goods.
A good example of this financial market-driven short-termism can be seen in a 2004 study of CEO compensation conducted by United for a Fair Economy and the Institute for Policy Studies (PDF). It found, "CEOs at companies that outsource the most U.S. jobs are rewarded with bigger paychecks … average CEO compensation at the 50 firms outsourcing the most service jobs increased by 46 percent in 2003, compared to a 9 percent average increase for all CEOs at the 365 large companies surveyed by Business Week."
There’s no doubt that offshoring decent jobs that paid living wages was good for those firms’ short-term bottom lines, and those corporate managers were rewarded on that basis. But was it good for the economy? With consumer spending in the tank and inequality at levels not seen since the robber barons were tamed, it’s hard to argue that such short-term thinking served the nation’s economy very well.
Let’s return a moment to the fact that banks aren’t lending money. There are multiple causes for the freeze, including the fact that businesses and individuals aren’t in the market to borrow money to purchase goods or expand their operations. Another reason is that, as Bloomberg reported, "With three weeks to go until the end of the year, financial institutions are vying for loans that mature after Dec. 31 to bolster their balance sheets as they prepare to report to investors."
As the financial meltdown forces the economic establishment to chart a new course, we should not only let the financial sector contract significantly, but curtail its influence as well. That can be achieved in a number of ways: by banning corporate compensation based on firms’ stock values, creating new forms of socially responsible financing or encouraging the expansion of what Bill Gates calls creative capitalism -- a nebulous phrase that's been interpreted to mean adding corporate social responsibility to the traditional imperative of maximizing profits over the short term.
That won’t be easy -- and would be politically impossible in a normally functioning economy. But letting a few banking giants sink, and the financial sector as a whole write down massive amounts of the junk it produced during the last decade just might help focus the mind on newer and more creative models of finance.